I'm trying to get a grasp on how exactly inflation works. What I've read so far seems to be contradictory. In some articles I've read that government spending is always(?) inflationary, and in others I've read that as long as the money supply roughly matches the productivity of the economy, then money supply won't be inflationary. Could someone explain using the following example what the inflationary effects would be and what is causing them?

Let's say we have a 1 trillion dollar economy. All else being equal:

Example A - The government borrows 50bn and uses it to build productive infrastructure.

Example B - The government borrows 50bn and divides it evenly between every person's bank account (and assume that most people spend most of it in country).

3 Answers
3

Inflation is a monetary phenomenon. Your first example involves only fiscal policy. Fiscal policy by itself does not affect inflation.

Let's assume we have a closed economy, where nobody can borrow or lend. Money circulates in it. If there is not any monetary policy, the money supply will remain still, therefore a specific amount of money is going to circulate. We cannot borrow/lend as a society to buy more/less, so demand pull inflation cannot occur. Also, the wages cannot rise in total, therefore the costs of production remain still. In other words, cost-push inflation will not occur either.

However, there is a problem on that. How do we measure inflation in first place? We create a basket of goods that represents the society and according to this we measure the price changes. What if that citizens change preferences? Therefore, even in this case there would be inflation, caused by statistical error.

The simple answer to your question is that inflation happens when the money supply outpaces the productive capacity of the economy. What's more, government borrowing does not increase the money supply in and of itself.

First, let's recall that inflation happens when there is an undersupply of goods relative to the amount of money in circulation---or when there is an oversupply of money relative to the quantity of goods available for sale. Increasing the money supply may lead to inflation depending upon the level of output.

As I wrote above, if a government borrows an additional dollar from the public markets, no new money has been created. For example, the US Treasury coordinates Treasury bill, note, and bond auctions to ensure that the government has available to it funds to meet its ongoing expenses. Certain banks called primary dealers must submit bids for those Treasuries, hence those bonds are always bought, no matter market conditions. What's more, those primary dealers buy those bonds with customer deposits, the savings of institutions and households.

The Fed and other central banks can make minor adjustments to the size of the money stock by influencing money creation among private banks. I urge you to read about the money multiplier to get a better handle on how central banks change policy to influence money creation among those private banks. You'll want to read about M0 and M2, and you will want to read carefully how M0 expands into M2 as banks make new loans to businesses and households.

I should stress that central banks are highly data dependent and respond to figures that not only indicate current GDP growth, but projected growth. They do not influence money creation proactively.

Let's think carefully about a couple of different scenarios so that we see your examples in action.

Example A

Imagine your government borrows $50bn to build new roads. When there is high unemployment and low utilization---demand for cement, rebar, trucks is low---building roads will likely not be inflationary. If the construction sector is at full employment, however, orders to build roads will drive up wage costs. Likewise, if private and public developers compete for cement, additional plans to build roads will likely bid up the value of cement.

Example B

Imagine the government borrows $50bn to insert into everyone's bank accounts. The answer depends upon whether that money will be spent immediately. If it will, then yes, consumers will likely bid up the value of goods with their new money, hence such government action will lead to inflation. If, however, that money will not be spent, then the government has done nothing but engaged in an accounting transaction. Imagine that everyone took their share and paid down mortgage debt. What has happened but that the government replaced private sector mortgage debt with public debt?

Lastly, there are those that would like you to believe that "inflation is everywhere and always a monetary phenomenon." That line comes from Friedman, and should be interpreted loosely. If you were to look at M0 in the US from 2008 onward, you would be shocked by its growth. However inflation has been extraordinarily subdued since the crisis. Look at M2 however, and it becomes clear that despite extraordinary Fed action, the supply of broad money has not grown. That's why inflation has remained low. How you measure money matters.

$\begingroup$Thanks for that explanation. I like it. Just a question though about the 50bn making it's way in to the money supply. In Ex A, that 50bn pays wages, so it should certainly enter the money supply I would have thought. And even if it is saved, unless it is long term investment, it is still very liquid and effectively in the money supply.$\endgroup$
– ervDec 16 '16 at 4:07

$\begingroup$Just one other question: Your description of inflation in your second paragraph... when we look at the empirical data is this reflected in reality?$\endgroup$
– ervDec 16 '16 at 4:12

$\begingroup$@erv. I made some changes to the text of the answer. We've got to be careful, though. That \$50bn does not make its way into the money supply. Think of that \$50bn as money borrowed from savers that is spent by the government. However the money would have been spent anyway because savings is almost always matched with investment. The description of inflation in the second paragraph is the definition of inflation. The measures we use to describe inflation are imperfect. What's more, inflation can happen regionally and in specific goods/services, (e.g., energy).$\endgroup$
– CAMELSDec 16 '16 at 15:02

In addition to what CAMELS says, it's not just the money supply but the product of money supply and money velocity.

To make matters even more complicated, the wider measures of money like M2 can either be interpreted as just `more money' or as implicit multipliers on the narrower measures. (In the end, it doesn't make too much of a difference with definition you use, as long as you don't confuse yourself or others about reality.)